Models in macroeconomics



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Chart
5a
. A naïve econometrician running regressions of inflation on the output gap 
would see only the red circles and identify the negative monetary policy trade-off line, rather than the positive 
Phillips curve relationship. 
Successful monetary policy will make the Phillips curve harder to identify in the data. But in practice, 
policymakers cannot always perfectly offset fluctuations in demand. There will be unforeseen shocks that 
cause output and inflation to evolve differently to their forecasts. These will appear as if they are shifts in the 
preferred trade-off (
Chart 5b
). If these shifts are large relative to the cost-push shocks in 
Chart 5a
, we may 
be able to observe the Phillips curve. But as policymakers, even though the Phillips curve underlies our 
models, we should always be doing our best to make it disappear in the data. 
This example highlights that it may not be possible to see the true relationships from looking at the data 
alone. We often need to use a model in such situations. Models can show us a broader picture and help us 
consider alternative mechanisms that may be driving the data. (Another option, for the econometricians in 
the room, is to come up with clever instruments, but they are not always available.) 
Current challenges 
 
So far I have discussed some of the benefits of using macroeconomic models, as well some of the debates 
of the past that many economists thought had been settled. But compared to mapmaking, economic 
modelling is still a very imprecise science. And probably it will always be, as our economies and our 
understanding of them continue to evolve. (So too do our technical modelling capabilities.)
As a result of all this, there will always be ample scope for improvement. I would like to pick out three areas 
where some of our standard models have been accused, with some justification, of being somewhat lacking: 
first, incorporating banks and the 
financial sector
; second, realistically modelling people’s 
expectations
of the 
future; and third, taking into account the ways in which the 
distribution
of different households and firms in 
the economy may matter.
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But I should also emphasise that I think there has been impressive progress on 
all three fronts. This list is also not exhaustive 
– I will briefly mention other areas where models could be 
improved. 
a) 
The financial sector
As in the 1970s, the biggest challenge to macroeconomic models has come from a real-world event: the 
2008 financial crisis. Economists were charged with having ignored the financial sector in their models;
23
Others have picked out similar sets of challenges, for example, Yellen (2016), as well as Vines and Wills (2018) in the overview 
article in the 
Oxford Review of Economic Policy
special issue. 


All speeches are available online at www.bankofengland.co.uk/speeches 
12 
12 
some blamed policymakers for not acting against growing financial imbalances; and above all, economists 
were criticised for not predicting the crisis. 
While the charge that macroeconomic models failed to predict the financial crisis is fair, I think it helps to 
understand the reasons for that prediction failure. Models are used for forecasting, but it is by no means their 
only (or even their primary) role in macroeconomics. And most forecasting models are designed to predict 
the more frequent peaks and troughs we had seen in the economy in most of the post-war period, not rare 
events such as crises. 
Often the best we can do is to improve our understanding of crises that have happened in the past or in 
other countries and try to avoid the same phenomena happening again 
– and be prepared to react if they do 
happen. But even when we were able to identify worrying financial imbalances that might lead to crises, this 
would not mean that we would be able to predict their timing with any accuracy.
24
I should emphasise that prior to the crisis, there were also large parts of the economics profession that did 
pay close attention to banks and the financial sector. There are entire literatures exploring bank runs and 
liquidity risk, moral hazard in banking, market microstructures and other important issues.
25
With hindsight, it seems clear that macroeconomics should have included more of these insights into its 
models.
26
This is exactly what has happened since the crisis, with a mountain of new papers that have added 
further insights to our understanding of real economy-financial sector interactions. It is easy to argue this 
after the fact, however. Models cannot include every aspect of reality, so the model-builder has to decide 
which features matter for a given question.
27
I should add that even though many mainstream 
macroeconomic models did not feature a financial or banking sector before the crisis, the insights from the 
financial economics literature arguably played an important role in the response to the crisis, particularly in 
the form of liquidity provision through quantitative easing programs. 
b) 

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